Abstract
Nat Cat risks are not insurable by traditional insurance mainly because of producing highly correlated losses. The source of such correlation among buildings of a region subject to a natural hazard is discussed. A decomposition method is proposed to split Nat Cat risk into idiosyncratic (and hence insurable) risk and systematic risk (carrying the correlated part). It is explained that the systematic risk can be transferred to capital markets using a set of parametric CAT bonds. Premium calculation is presented for insuring the decomposed risk. Portfolio risk-return trade-off measures for investing on the parametric CAT bond are derived. Multi-regional and multi-hazard parametric CAT bonds are introduced to reduce the risk of the investment. The methodology is applied on a region with about 3000 residential buildings subject to flood hazards.
Highlights
Natural Catastrophe (Nat Cat) risks have been argued to be uninsurable as they do not allow the law of large numbers to be exploited for insurance purposes (Grossi2005)
We propose to transfer the systematic risk into capital markets using a set of parametric CAT bonds
CAT bond interest can be divided into two parts: (1) the interest generated from the bond principle investing on a trust which is governed by risk-free rate, and (2) the spread of the catastrophe bond which is paid to the investors to compensate the involved risk
Summary
Natural Catastrophe (Nat Cat) risks have been argued to be uninsurable as they do not allow the law of large numbers to be exploited for insurance purposes (Grossi2005). The produced losses are highly correlated which violate the condition for the law of large numbers. This correlation issue is the root of creating a heavy tail distribution for Nat Cat losses which means higher maximum possible aggregate loss, higher expected loss, and higher dispersion in the loss distribution. These issues demand insurers to provide large capital (Charpentier and Le Maux 2014), limit their exposure Zanjani (2006), and charge premiums significantly above actuarial fair value (Banks 2005) which lead to low insurance take-up rates
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